QUESTION-3:[151 Suppose that you have $1000 to invest in the bond market on Janu

Question

QUESTION-3:[151 Suppose that you have $1000 to invest in the bond market on January 1,2017. You could buy a one-year bond with an interest rate of 4%, a two-year bond with an interest 5%, a three-year bond with an interest rate of 5.5%, or a four-year bond with an interest rate of 6%. You expect interest rates on one-year bonds in the future to be 6.5% on January 1, 2018, 7% on January 1 , 2019, and 9% on January 1,2020. You want to hold your investment until January 1, 2021.Which of the following investment alternatives gives you the highest return by 2021 (a) buy a four-year bond on January 1,2017 (b) buy a three-year bond January 1, 2017, and a one-year bond January 1, 2020, (c) buy a two-year bond January 1, 2017, a one-year bond January 1, 2019, and another one-year bond January 1, 2020, or (d) buy one-year bond January 1, 2017, and then additional one-year bonds on the first days of 2018, 2019, 2020?

Explanation / Answer

a.) Interest on 4-Year bond=6%

If held till maturity, return = (1+0.06)4 -1 =1.2625 -1 =0.2625 or 26.25%

b.) Interest on 3-Year bond=5.50%

Interest on 1-Year bond on 01-Jan-2020 =9%

Total Return in this case ={(1+.055)3x1.09}-1 = 1.2799 -1 =0.2799 or 27.99%

c.) Interest on 2-Year bond=5.00%

Interest on 1-Year bond on 01-Jan-2019 =7%

Interest on 1-Year bond on 01-Jan-2020 =9%

Total Return in this case ={(1+.05)2x1.07x1.09}-1 = 1.2858 -1 =0.2858 or 28.58%

d.) Interest on 1-Year bond=4.00%

Interest on 1-Year bond on 01-Jan-2018 =6.5%

Interest on 1-Year bond on 01-Jan-2019 =7%

Interest on 1-Year bond on 01-Jan-2020 =9%

Total Return in this case ={(1+.04)x1.065x1.07x1.09}-1 = 1.2918 -1 =0.2918 or 29.18%

Hence, the maximum return is in option-(d)

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